What is the compensation committee? Definition, roles & best practices
The compensation committee determines all executive compensation packages, including salary and any other forms of compensation. Depending on the company’s bylaws and the compensation committee's charter, the committee will either have the authority to decide the amounts and components for executive compensation packages on its own or make strategic recommendations to the board for a final vote.
While this may sound simple, corporate boards are highly regulated and have a lot of pressure from investors who want assurance that executive pay correlates to performance. A modern executive compensation package is quite complex, often requiring intense evaluation during its design and attracting much scrutiny from stakeholders.
To help you understand and properly utilize your compensation committee, this article will explain:
- How to define the compensation committee
- What the compensation committee does
- Who serves on the committee
- The authority, duties and responsibilities they have
- Compensation committee best practices
What Does the Compensation Committee Do?
Designing an executive compensation program is among the board’s core responsibilities, often owned by the compensation committee (sometimes called the remuneration committee). This committee aims to develop an executive pay package that incentivizes the right behavior and moves the company towards its business goals, but that’s not all on its agenda.
Key Compensation Committee Functions
In general terms, the compensation committee acts in three capacities: advisory, strategic and administrative.
- Advisory: In this capacity, they serve as advisors to the board. In the capacity of their strategic role, compensation committees must be able to demonstrate to the board and shareholders how achieving corporate goals correlates with and supports executive compensation packages.
- Administrative: In an administrative capacity, compensation committees must perform much research, including identifying studies, evaluating alternatives, and designing the most appropriate components for executive compensation plans. Their plans must meet the specifics of industry rules and regulations and follow the company’s governance practices.
- Strategic: The committee also takes on the primary responsibility of ensuring that compensation plans produce the intended results. Compensation committees need to craft packages that both incentivize their executives and hold up to shareholder scrutiny.
Who Serves on the Compensation Committee?
The current environment around executive compensation requires boards to appoint compensation committees comprised solely of independent directors. The appointees should collectively represent diverse business skills and industry expertise.
Independence and skills are essential, and it’s also important that the committee understands exactly what the board needs from them. Boards must develop a written description of the committee’s role, duties and responsibilities, leaving nothing to chance.
What Is the Usual Composition of a Compensation Committee?
A compensation committee should include a minimum of three directors, two of which are independent, according to requirements from the SEC. The board elects these members at its annual meeting.
What Are the Qualifications for Compensation Committee Members?
Committee members should have relevant skills and experience that make them qualified to research, assess and recommend executive compensation plans. Common qualifications among compensation committee members include experience with:
- Human resources
- Employee benefits
What Authority Does the Compensation Committee Have?
Though compensation committees are independent, they still have some authority. In general terms, compensation committees:
- Select the components for executive compensation packages, along with the corresponding amounts.
- Specify the value of the total compensation packages for executives.
While the committee bears the authority for compensation, consistent pressure from investors requires the committee members to establish clear performance targets and a clear mechanism for measuring whether executives have met their benchmarks.
What Does a Compensation Package Include?
The components of compensation plans, as well as how those components are structured and implemented, vary substantially between corporations. Compensation trends often evolve, but compensation plans commonly consist of one or more of the following components:
- Base Salary: may also be referred to as base pay or basic salary
- Bonuses: typically short-term goals with cash-based incentives
- Long-term Incentives: often come with corporate equity
- Benefits: components such as health, dental or life insurance; vacation time; or company-sponsored savings and investment plans
- Perquisites: grants or privileges such as company cars, business cell phones and use of corporate properties
What Are the Duties and Responsibilities of the Compensation Committee?
Shareholders want to know how the board is approaching its compensation design — a story that the compensation committee is expected to tell in the Compensation Disclosure & Analysis (CD&A) section of the proxy statement. Investors are also pressing boards to think about how compensation decisions can impact the company’s long-term strategy for growth, whether negatively (e.g., Wells Fargo, Persimmon) or positively (e.g., talent acquisition, sustainability initiatives).
The primary duties and responsibilities of the compensation committee are all in service of providing strategic compensation recommendations to the board. To do this, compensation committees should focus on:
- Develop a philosophy around compensation in keeping with the corporation’s mission and values. This incorporates the ratio of salary to benefits, competitiveness, correlation to business strategy, drivers for increases or incentives and how the philosophy affects employee morale and job satisfaction.
- Approve any compensation in which board directors or officers may be able to participate. This duty may be challenging for some committees because the full board generally votes on it, and the board may allow shareholders to have input on it rather than take a chance on causing unrest with shareholders because of compensation amounts.
- Recommend, oversee and approve other benefits in the form of corporate equity, stocks, perquisites and more.
- Oversee employment contracts in conjunction with board oversight and, under some circumstances, with shareholder approval.
- Recommend or approve the CEO’s compensation package to the board, along with compensation for submitting direct reports. The compensation committee also serves as a liaison between the CEO and the board on all compensation and human resources issues for senior executives.
- Reviews the board members’ compensation components and amounts and recommends changes to the board. The board considers their recommendations and votes on them according to their duty of care, which means placing the organization's interests above their own.
- Outline performance metrics and how they correlate to the targets defined in the executives’ compensation packages. The compensation committee compares performance to targets in deciding which benefits and awards the executive is entitled to under the agreement.
As advisors to the board, compensation committees may seek professional experts to help them in their role, including legal, accounting or compensation professionals.
In addition to working closely with the board, compensation committees usually work with finance or audit committees to approve the overall compensation budget so that individual compensation plans are fully funded.
Compensation Committee Best Practices
To be effective, compensation committees need to excel in many different areas. They have to liase with the board, executives, shareholders and any external stakeholders that assist the process.
The best practices for achieving this kind of comprehensive work include:
- Focus on Disclosure & Engagement: Whether a company’s CEO compensation is high or low is always relative. Peer group selection is a critical part of the compensation committee process; proxy disclosure should (1) detail how the peer group was selected and (2) visualize where the company falls within the peer group. Today’s boards must use the CD&A to tell their company’s pay story. Compensation committee members should also be prepared to engage with shareholders on the topic of CEO pay.
- Leverage Compensation Consultants: Compensation consultants typically play an important role in both the compensation strategy and disclosure; they advise compensation committees on peer group selection and incentive design, often through the lens of investors and proxy advisors. A recent episode of “Inside America’s Boardrooms” reviews key criteria for selecting and evaluating a compensation consultant.
- Compile Compensation Data: The success of today’s compensation committees relies on whether they have the right data at their fingertips. Not only must they have access to the same data their investors have, but they should have access to tools that enable peer group modeling.
- Create Independence: The compensation committee needs to function independently from the board. Be sure to choose impartial committee members and limit how long each member serves to limit any bias.
- Report to the Board: The board should have an open line of communication with the compensation committee. This provides assurance that the committee is operating legally, ethically and in the best interest of the company.
Deliver Compliant & Competitive Executive Compensation
Compensation committees today are heavily scrutinized by boards, regulatory bodies and shareholders. The approach of the compensation committee should be to fulfill their duties and responsibilities while helping the board provide meaningful oversight. But how can the compensation both assure the board and ensure that the compensation they set is commensurate with the position level and performance?
The Board & Executive Benchmarking Platform from Diligent empowers your board with the accurate pay-for-performance data they need to independently analyze executive pay. With Diligent, you can comply with the SEC’s requirements while offering compensation that both motivates executives and passes the board vote.